A decade ago when 10 of the largest investment firms agreed to the Global Settlement to resolve conflicts of interest between their investment banking and equity research businesses, it was generally regarded as a positive step toward protecting the less sophisticated retail investor.
Instead it has resulted in a dramatic decline in the quality and quantity of analyst research, in turn hampering the launch of initial public offerings, impeding the nation's economic recovery and causing damage to all market participants, including pension plans and other institutional investors.
Securities and Exchange Commission, the New York Stock Exchange, the North American Securities Administrators Association, the National Associate of Securities Dealers and New York State Attorney General Eliot Spitzer announced in 2003 the final terms of the Global Settlement of Conflicts of Interest Between Research and Investment Banking, calling for $1.4 billion in enforcement payments from the firms.
Following the Global Settlement there was an almost immediate drop in the number of companies covered by research analysts, averaging 114 dropped stocks per firm. As of Dec. 31, 2012, out of 5,044 exchange-listed companies, 1,443 had no meaningful analyst coverage of their stocks. That figure represents nearly 29% of all companies listed on major exchanges. Additionally, of the stocks without meaningful analyst coverage, 1,105 have market caps of less than $250 million, representing 55% of all listed companies in that market cap group.
These microcap stocks represent the farm team for tomorrow's Fortune 500 list. But when the shares of a publicly traded company stock have limited or no liquidity, it enters the nether world of “orphaned” stocks. Such a stock might languish indefinitely in the aftermarket, often with no investment banking sponsorship — i.e., research coverage — or limited institutional ownership or both. Aftermarket support creates visibility, marketability and, most importantly, liquidity in a publicly traded stock. This requires active effort from management or its investor relations firm in an effort to secure quality analyst coverage. In short, there is a causal relationship between high-quality analyst coverage and a stock that is widely held, actively traded and fully valued.
A half century ago, individual investors owned more than 90% of all U.S. stocks. Today, institutional investors own and control almost 70% of the shares of U.S. corporations with the top three categories of institutional ownership being mutual funds (28%), private pension plans (11%) and government pension plans (9%).
Individual investors are much more likely now to own model-generated portfolios of index-tracking mutual funds and exchange-traded funds than individual stocks. Without the support of individual investors, small IPO stocks are unable to climb the ladder toward institutional financing, and often never reach their full potential. The same buyers who no longer are there to support IPOs are also not there to support fledgling stocks in the aftermarket.
The absence of individual stock owners also has the unintended effect of keeping away institutional investors. Pension funds and other institutions generally will only take positions in stocks that have established liquidity, and that cannot exist without a solid base of individual stock owners. Institutional ownership is critical because it confers legitimacy since institutional investors tend to be more judicious and careful in their investments than private individuals.
Before initiating coverage, sell-side equity research analysts check whether institutions will consider buying the relevant stock, because commissions received by their sales and trading colleagues from stock trades ultimately finance the research. Analyst coverage confers legitimacy and is an indication that a stock is of institutional quality. Institutions can take large positions that absorb overhang (inclusive of dilutive securities or large blocks of stock available for sale), increase volume and, most importantly, drive up the price. Analyst coverage is all the more coveted because more than 22% of all listed stocks — one out of every five in the U.S. — have no coverage.
The Global Settlement also has completely changed how Wall Street delivers equity research and what is valued by institutional investors. Today, premium services such as investor conferences and access to an issuer's management have become much more highly valued. Investors seem to prefer direct interaction with CEOs and CFOs over traditional written research. With the Global Settlement's severing of the ties to investment banking and the associated loss of banking revenue, research departments, which are exceptionally costly to operate, had to develop this “premium services” model as the means to more fully monetize their platforms.
Despite the radically changed nature of equity research, it continues to be valued by buy-side institutions. However, until equity research and analyst coverage becomes economically viable for Wall Street to make it available to the one out of four public company stocks without meaningful analyst coverage, orphaned public stocks will remain a major public policy dilemma.
But with commissions compressed and trading spreads decimated by market reforms in 1997 and 1998, and the advent of decimalization in 2001, Wall Street has no economic incentive to staff up the sales, trading and research desks to cover these smaller public companies, and that's bad for everyone. A simple solution would be a program that permits tick sizes (the minimum trading size for stocks) of 5 cents, 10 cents and 25 cents for smaller stocks. Tick size reform must be the most crucial element of any market structure reform, and we believe this program will be the most effective means to adequately compensate Wall Street to cover orphaned stocks and, more importantly, to provide a needed catalyst to the small-cap IPO market and our country's job creation engine.
Changing tick sizes is not a panacea, but it could represent a meaningful beginning. Of course, more work remains in implementing certain provisions of the JOBS Act, or Jumpstart Our Business Startups Act, and passing legislation that completely eliminates any post-IPO quiet period and allows all existing public companies that meet the criteria for an “emerging growth company” to take advantage of the JOBS Act provisions.
Taken together, three reforms — elimination of the quiet period for equity research, issuer controlled tick sizes and the application of emerging growth company status to existing public companies that qualify — would provide the shot in the arm so desperately needed by the U.S. equity capital markets. The result would be the resurrection of the small-cap IPO — the greatest job creation engine in history. n
Timothy J. Keating is CEO of Keating Capital Inc. and president of Keating Investments LLC, both of Greenwood Village, Colo. Keating Investments is the investment adviser to Keating Capital, a publicly traded business development company specializing in making pre-IPO investments in emerging growth companies.